5 Reasons Why Small Businesses Get Audited

businessman completing an audit of a small business

For individual taxpayers and small business owners alike, the idea of an IRS audit can strike fear into one’s heart. And many experts agree that the frequency of audits for small and medium-sized businesses is likely to increase in tax year 2023 and beyond, especially for businesses with relatively low annual revenue. [1] (In tax year 2021, for example, 13 of every 1,000 taxpayers with low annual revenue were audited, compared with just 2.6 of every 1,000 for all other taxpayers.)

Although there’s nothing you can do to completely guard against an audit, the IRS tends to look for a few common red flags. Avoiding these red flags can significantly reduce your risk of an audit. Below, we discuss five of the most common reasons why the IRS might audit your small business, as well as some steps you can take to reduce your risk.

Why Do Small Businesses Get Audited?

The purpose of an IRS audit is to ensure that the person or entity being audited isn’t avoiding federal and FICA taxes—most commonly done by under-reporting or hiding income, over-reporting expenses or taking ineligible deductions, or misclassifying employees. As a result, the biggest red flags are those that give the appearance of one or more of these tax avoidance methods.

1. Reasonable Salary

As an S-Corporation owner, paying yourself or other shareholder-employees an unreasonably low (or high) salary can trigger an audit. Too-low salaries are often intended to avoid payroll taxes; for example, an S-Corp owner who pays herself only enough to contribute the maximum amount to a traditional 401(k) (tax-free) could be subject to back taxes, fees, and penalties unless she can prove her compensation was “reasonable.”

Any amount a business pays to an owner or shareholder-employee must qualify as “reasonable compensation.” This can be tricky, as the IRS doesn’t impose a strict dollar amount when assessing whether compensation is reasonable. Instead, this calculation can depend on the employee’s skill level, the size of your business, the type of industry you work in, and a variety of other factors.

It’s crucial to conduct market research to ensure the salaries you’re paying are reasonable. This is where RCReports can help. Our team has the data to assess reasonable compensation for a broad range of industries and businesses, giving you peace of mind that your reasonable compensation payments are defensible.

2. Losses and Deductions

Small business owners frequently itemize deductions on their income tax returns, including costs for:

  • Maintaining a home office
  • Paying for internet and other overhead expenses
  • Travel costs
  • Vehicle use and mileage
  • Business-related food and beverage expenses
a businessman auditing a small business showing the importance of a business audit

Although these deductions in and of themselves aren’t necessarily a red flag, having “too many” deductions (again, not something specifically defined by the IRS) can trigger an audit.

For an expense to be classified as a legitimate business expense that can be deducted, it must be both “ordinary” and “necessary.” This means the expense must be 1) common and accepted in your trade or business; and 2) helpful and appropriate for your trade or business.

Ensure that any deductions you’re taking can be backed up under both the “ordinary” and “necessary” standards before claiming them. Keep receipts and thorough documentation of these expenses, preferably in digital form with a backup. When in doubt, it may be best to avoid a particular deduction.

Business losses are another audit trigger. It’s common for small businesses to experience a net loss for a particular tax year, especially during tough economic times or while you’re still a fairly new business. But if you claim business losses for more than two of every five tax years, the IRS may begin to ask whether your business is a legitimate one or simply a hobby.

3. Shareholder Distributions

Reasonable compensation comes into play again with the third audit red flag—shareholder distributions. If you’re making distributions to shareholder-employees (or yourself) while not paying reasonable compensation for services provided, the IRS may look at this as a way to avoid payroll taxes.

If you can’t afford to pay reasonable compensation, don’t worry—in fact, you don’t have to pay yourself a salary at all. Just remember that you can’t make a shareholder distribution without also providing reasonable compensation to that shareholder-employee. In other words, your choices are:

  • No compensation or shareholder distributions
  • Reasonable compensation
  • Reasonable compensation and shareholder distributions

If you opt for the first option and decide to make retroactive distributions in the future, it’s essential to be aware that additional costs may arise. This includes fees that need to be paid for the same look-back period.

4. Employment Tax Compliance

close up of the businessman's hand using an approval stamp

Employee misclassification is the fourth most common trigger for a small business audit. If you have few employees but lots of independent contractors, the IRS may want to dig deeper to see whether you’re incorrectly classifying these workers to avoid payroll taxes, workers’ compensation and liability insurance, and overall labor costs.

Under IRS rules and regulations, a worker is an independent contractor only if:

  • They control their schedule
  • They control what work they perform
  • They control the conditions under which they perform the work

The business can control only the result of the work performed. If you require your independent contractors to stick to a schedule you set or work in a specific place, or if you dictate their work assignments and when they are completed, you could be treading the line between contractor and employee. And misclassifying an employee can be an expensive mistake, as the business will be liable for back payroll taxes, fees, and penalties. Review the IRS guidelines carefully when bringing anyone new on board your business. [2]

5. Entity-Level Issues

Finally, if you run a largely cash business, you could be at risk of an audit. Sometimes this can’t be helped—but it makes it all the more important to minimize other red flags where you can. Some of the most common cash businesses include:

  • Restaurants, coffee shops, and bars
  • Beauty salons and barbershops
  • Lawn and garden services
  • Street vendors
  • Nannies and childcare providers

Since cash transactions are harder to track than digital ones, it can be much easier to underreport income at cash businesses. If you have frequent or regular cash transactions, you’ll want to document transactions thoroughly and be able to verify your income.

References

1. Freednan, M. (2023, April 28). Are More SMB Tax Audits Coming? Business 

News Daily. https://www.businessnewsdaily.com/tax/audits 

2. Internal Revenue Service. (2023b, April 7). Independent Contractor 

(Self-Employed) or Employee? https://www.irs.gov/businesses/small-businesses-self-employed/independent-contractor-self-employed-or-employee 

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